State attorneys generals from 40 states are expected to announce on Wednesday a probe into the mortgage-servicing industry, an effort some of them hope will pressure financial institutions to rewrite large numbers of troubled loans.
The planned investigation comes in the wake of recent allegations that mortgage-servicers, which include units of major banks such as Bank of America Corp., submitted fraudulent documents in thousands of foreclosure proceedings nationwide.
The banks say the document problems are technical—largely the result of papers approved by so-called robo-signers with little review—and don't reflect substantive problems with foreclosures. Still, they have drawn criticism from consumer advocates and state and federal lawmakers.
"I think the mortgage-servicing firms need to understand that they face real exposure now, and they would be well advised to take this very seriously, to clean this up by doing loan workouts to keep people in their homes, which up till now they've just paid lip-service to," said Ohio Attorney General Richard Cordray.
Some in Congress have called for a moratorium on all foreclosures until the documentation issue is resolved, though senior Administration officials Monday again declined to endorse that idea. Servicers that have lied to courts by filing incorrect paperwork "need to suffer the consequences for their irresponsible actions," said Shaun Donovan, the Secretary of the U.S. Department of Housing and Urban Development. But "where we have not found problems with particular servicers…we do have some risk of going too far."
The attorneys' general immediate aim is to determine the scale of the document problems and correct them. But several of them have said that the investigation could force the lenders and servicers to agree to mass loan modifications or principal forgiveness schemes. Other possibilities include financial penalties or changes in mortgage servicing practices.
Lenders and servicers have largely resisted reducing principal on mortgages, instead focusing on interest-rate reductions or term extensions. Banks say they are worried about lawsuits from investors, some of whom could lose money in a principal write down.
Former New Jersey attorney general Peter Harvey, now a trial lawyer in New York, said that a settlement with state attorneys general would likely "to give the banks some cover" to make changes that might otherwise result in lawsuits by investors in mortgage-backed securities.
The mortgage servicers had little to say in response to an impending multi-state probe. "We will work with the attorneys general to address the concerns they have expressed," said Dan Frahm, a spokesman for Bank of America.
"We look forward to cooperating with the attorneys general," said a spokesman for J.P. Morgan Chase & Co., which has suspended foreclosure sales and evictions in 23 states in response to questions about it use of robo-signers. A spokesman for Citigroup said the company, has "no reason to believe our employees have not been following" proper procedures in processing foreclosures. A spokeswoman for GMAC Home Mortgage Inc, a unit of Ally Financial, Inc, said it continued to review its loan documents.
The number of servicing companies that will be included in the probe hasn't been determined.
Iowa attorney general Thomas Miller, who is leading the effort, said his office might take cues from an investigation brought by Massachusetts attorney general Martha Coakley. She successfully pressured Bank of America Corp. in March to reduce mortgage-loan balances by as much as 30% for thousands of borrowers, using the threat of a lawsuit to get a settlement, though documentation problems were not at issue then.
The primary weapon the states could wield would be their respective laws against unfair and deceptive acts and practices, said Prentiss Cox, a professor of law at the University of Minnesota and former Assistant Attorney General in Minnesota.
Those laws are easier to apply, however, when a lender misleads a borrower than in pursuing problems with foreclosures related to documentation, he said. Individual attorneys general could also bring actions under states' various foreclosure laws.
Illinois Attorney General Lisa Madigan said she was preparing to introduce legislation meant to tighten foreclosure laws and prevent document errors in the future. She also is pushing federal representatives to resurrect a bill that would allow bankruptcy judges to "cram down," or cut, a troubled homeowner's mortgage debt.
"The immediate goal is to stop fraudulent foreclosure and to require that the lenders and servicers are following the law. But that's the bare minimum. That's what they have to do to follow the law," she said.
Nearly a dozen attorneys general nationwide, including Ms. Coakley and Mr. Miller, have called on lenders and servicers to suspend foreclosures until document irregularities are studied and corrected.
Top lawyers from multiple states have gone after mortgage lenders before. In 2008, Bank of America Corp. settled charges brought by 15 attorneys related to accusations of predatory lending in its Countrywide Financial Corp. unit, granting loan modifications worth $8.4 billion to thousands of homeowners.
Mr. Cordray, of Ohio, last week became the first attorney general to sue a mortgage servicer, when he filed suit against GMAC Mortgage LLC. The suit also named as a defendant GMAC employee Jeffrey Stephan, an alleged "robo-signer," who said that he signed off on thousands of court documents related to foreclosures without reading them first.
GMAC announced that it was suspending foreclosures in the 23 U.S. states where judges are required to sign off on them after news of Mr. Stephan's activities surfaced. J.P. Morgan Chase & Co.'s Chase Home Mortgage unit suspended judicial foreclosures soon after, and Bank of America followed suit. On Friday, Bank of America widened its foreclosure freeze to all 50 states.
Some attorney generals would like to look beyond the narrow issues raised by the robo-signing. The issue "I'm most engaged in right now is the big servicers who are initiating foreclosures while the borrower is in the modification process," said Arizona Attorney General Terry Goddard.